Volatile markets

March 2011- The factors that affect metals markets have become increasingly complex, contributing to volatility, higher prices and concern among businesses hoping to mitigate their financial risks.

"So many things have come together simultaneously to push the prices to these record-high levels" for copper and brass, says John Gross, a metals industry consultant with J.E. Gross & Co., Exeter, R.I., and publisher of the Copper Journal, an industry newsletter. "In the past five years, the market has experienced an unprecedented level of volatility."

That volatility has led to new highs and lows. Copper reached a low of $1.25 in 2008 and continues to climb to new heights above $4.00. Copper closed 2010 at $4.43, up $1.11 from the end of 2009, says Gross. The monthly average London Metal Exchange price for 260 brass fell to 54.08 cents in 2001 and rose by December 2010 to $3.21, he says.

These ups and downs are challenging for service centers and other companies that purchase metals, but they can better control their businesses if they gain an in-depth understanding of the markets and their drivers, says Dan Kendall, president of ABC Metals Inc., Logansport, Ind. Tracking the ever-shifting markets can be challenging, however.

In 2011, increased economic activity is expected to boost demand in copper end-use markets faster than the growth of refined production, and the copper market is expected to show a deficit of roughly 400,000 tons, according to the International Copper Study Group. The group acknowledges there is uncertainty in developing an outlook because of "the variable rate of economic recovery in many of the major copper-consuming regions that experienced a severe recession in the 2008-2009 period."

Despite the industry’s best efforts to track and predict movement, the many factors involved in creating the volatility also make it difficult to predict accurately a market’s next move, says Gross. "When we got to the end of 2008 and the price was down around $1.25, I can assure you there was nobody anywhere that would have predicted that the price would have risen as it did during 2009," he says. "That was a complete reversal of the down trend that had been in place. There was really nothing in the fundamentals at that point and time that would have suggested the market would have rebounded as it did throughout 2009."

Contributing factorsStronger demand for copper from China has contributed to the unprecedented level of price volatility in the past five years, says Gross. Until 2002, the United States was the largest producer and consumer of refined copper worldwide. That year, China surpassed the United States, and China now accounts for roughly 40 percent of global consumption, he says.

The focus has shifted away from the West and toward emerging markets such as China, South Korea and India, notes Edward Meir, senior commodity analyst at MF Global, a New York-based broker of commodities and listed derivatives. The West is increasing in its metal use gradually each year, but demand in the emerging markets is skyrocketing, he says.

"From a trade point of view, whenever the dollar weakens, other countries who are becoming more and more prominent players in the import of these metals, they are more aggressive in buying the metals," says Meir. "It is cheaper for them if the dollar weakens." By purchasing metal using their stronger local currencies, the companies offset the increase in the underlying price with their strong currency, he says. "Broadly speaking, when we see the dollar weakening against other currencies, primarily the euro, commodity prices move higher. When the dollar gains strength, commodity prices tend to move lower," says Gross.

The copper market also has experienced an avalanche of fund money coming to the commodity market, says Meir. "We have seen a lot of fund money come into this space because it is very easy for them to buy commodities. They don’t have to put a lot of margin down," he says, noting the typical types of funds include index, macro and commodity trading advisor funds.

The increased amount of hedge funds has contributed to accelerated speculative activity, says Gross. "Once a rising or falling trend becomes apparent, it becomes much more attractive to the speculative community to come in and participate, so it accentuates the moves up and down," he says.

Supply and demand also influences the market, and it was a fundamental driver throughout the 1970s, 1980s and 1990s, says Meir. However, supply and demand "has become less and less important over the last seven or eight years because other factors have come up," he says. "Fundamentals, fund money and the currency impact all variously have influence on the copper price, but supply and demand has become less and less important over the years."

Necessary educationKendall encourages others to educate themselves about the factors that drive the metals markets because a company’s business is only as good as the health of its customers. An important factor for companies to consider is how fluctuating material prices can affect their lines of credit from financial institutions. "I find that you had better have a really good relationship with your bank because as important as it is that you understand what’s going on in the copper market, you need to get your bank to understand," he says.

The lender with which ABC Metals works has learned copper is a metal that needs to be watched similar to how the bank watches precious metals. "They have expressed, ‘Its value is much greater than what we thought 10 years ago from a collateral standpoint,’" notes Kendall.

ABC Metals worked with its bank to help the bankers understand copper’s value. "Bankers know a lot about how to loan money, but they haven’t spent as much time on the collateralization of commodity metals," says Kendall. The company was able to increase its bank’s understanding and raise the collateralization of its copper inventory significantly, he says. It’s not unlike having one’s house appraised at a higher value without having to make improvements to the structure. "I haven’t had to put new carpet in, I just got them to see the value that was already present," says Kendall.

To mitigate risk exposure, some companies use the market as a hedging mechanism. Hedging is utilizing the futures market to transfer or manage risk. In 2008 when the market fell to $1.25, a company holding 1 million pounds of copper in inventory saw its value diminish by roughly $2.5 million from mid-year, says Gross. "If a company were hedging their inventories in the futures market, they would not have experienced that loss because the futures market would enable them to offset the loss in the physical market," he says.

Those who wish to learn more about the mechanics of the copper futures market should start with the basics, such as terminology, says Gross.

"Gain an understanding of how the options markets work and whether they can be useful in helping manage price risk. Learn the relationship between the Comex price and the price they are buying the copper at, and study trends in the market to see how those relationships may change over time," he suggests. MM

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